Question

3. The government aims at decreasing the natural rate of unemployment in the medium run. Which measure should the government adopt? Explain your answer. [5p]

Answer 1

Natural rate of unemployment will decrease if frictional unemployment and/or structural unemployment rate decreases.

Both these types of unemployment rate can be reduced by adopting expansionary fiscal policy which can be implemented in following ways.

(1) If government spending is raised, aggregate demand will rise, increasing output, income and employment. As a result, frictional unemployment and/or structural unemployment rate will decrease.

If as part of government spending, the government increases spending on education, it will increase human capital in medium run, therefore structural unemployment rate will decrease in medium run.

(2) If tax rates are lowered, disposable income and consumption will rise (if personal tax rate falls) and/or business investment will rise (if business tax rate falls), leading to higher aggregate demand, increasing output, income and employment. As a result, frictional unemployment and/or structural unemployment rate will decrease. To the extent the increase in investment is sustainable and increases capital stock in medium run, structural and frictional unemployment rate will remain low.